The highest interest rate increase in decades has the industry anticipating that investors will start changing course.
Multifamily may be less impacted than other CRE asset classes as the Fed attempts to slow down rising inflation, but there is still growing concern about higher cost of debt capital, tighter underwriting, lower prices and disappearing deals.
Yesterday, the Federal Reserve raised its benchmark interest rate for the third time this year. The 75-basis-point hike was the largest since 1994.
“Cash-flowing multifamily and industrial assets won’t be as severely impacted,” Richard Ortiz, co-founder and managing principal at Hudson Realty Capital, told Multi-Housing News. “These are also property types that continue to see significant rental rate growth.”
Shlomi Ronen, managing principal of Los Angeles-based Dekel Capital, said he expects to see stabilized cap rates hold firm in the long term as investors see rent growth keep up with inflation.
While rising mortgage rates may not be good for those seeking to buy single-family homes, the demand for multifamily and single-family rentals are expected to strengthen along with rents, National Association of Realtors Chief Economist Lawrence Yun said in a prepared statement.
But the rise in interest rates and volatility has led to a sharp uptick in cost of funds for both borrowers and lenders, CBRE Investment Management Chief Economist Sabrina Reeves told MHN.
“As a result, lenders are reducing leverage primarily out of concern for refinanceability,” she said.
Lenders have also tightened their underwriting standards resulting in lower loan-to-values, according to George Goyal, founder & managing principal of Three Pillars Capital Group, a Houston-based private equity firm. That also means operators need to bring more equity to the table, which will hurt investor yields because of higher debt.
The rising interest rates, which began with a 25-basis point hike by the Fed in March and continued with a 50-basis point increase last month, has already resulted in a shift in behavior due to concern about where rates are going to land in the next 12 months, according to Ortiz.
He noted both lenders and borrowers are going to continue to be more cautious going forward. Investors are going to be seeking higher returns on debt and equity and the cost of capital will go up.
“Lenders are likely going to be more conservative, but it will all depend on the type of deal—stabilized properties will continue to trade while there will likely be a slowdown of more speculative properties,” he added.
Meanwhile, cap rates will likely widen over the next 12 to 18 months to reflect what’s happening in the capital markets.
But the amount of discomfort investors will experience depends on their strategy and their horizon. “Those transactions that are more in our world, the bridge world, where borrowers are acquiring with the expectation to improve operations to the property and undergo asset renovations to increase rents will be less impacted by this volatility,” Ortiz told MHN.
Marcus Duley, chief investment officer of Walker & Dunlop Investment Partners, said he has already seen higher interest rates, in tandem with increased cost of debt capital, translate into lower loan proceeds due to “lender sizing constraints associated with minimum debt service coverage ratio requirements and higher underwritten exit test parameters.”
Further, he is concerned about the the low cap rate environment, particularly in multifamily and industrial, and properties with negative leverage where the cost of the debt is greater than the unlevered cash on cash yield. Duley said it has created a dynamic where buyers are determining if they will accept lower yields and/or sellers will accept lower prices.
Complicating matters is the fact that buyers and sellers are not in sync at this time on pricing, Goyal added.
“Buyers are looking for deals and good value whereas sellers either need to plan to hold for a longer term or accept lower values on their assets,” he said.
Henry Manoucheri, CEO of Los Angeles-based investor Universe Holdings, is anticipating a big shift as some owners take their properties off the market for the next several years if they can’t get the price they would have gotten just a few months ago.
“Those who need to sell will have no choice but to take a far lesser price than before,” he told MHN.
Universe Holdings has about $200 million in deals in escrow that will have to be repriced due to the change in their cost of capital and lenders’ more stringent underwriting standards.
He said the fundamentals for multifamily are still strong but he does worry about those who purchased properties with high leverage and have upcoming maturities within the next one to three years that are tied to volatile indexes.
“They are going to be in a world of pain, and they are going to have no choice but to sell,” Manoucheri said. “I think people who have not borrowed too heavily or leveraged too high are going to be OK. But the go-go days are over…I think we are most likely in the beginning of a recession and it will get far worse before it gets better.”
Meanwhile, Manoucheri said Universe Holdings will begin to be on the lookout for distressed properties.
‘Racing to Catch Up’
Mike Fratantoni, chief economist & senior vice president at the Mortgage Bankers Association, said in a prepared statement the Fed is “racing to catch up to economic events” with the increase and signaling more to come.
Fed Chairman Jerome Powell indicated on Wednesday that July’s rate increase could also be as high as 75 basis points.
“A federal funds target rate likely to reach almost 4 percent by the end of 2023 should be effective in slowing the economy and ultimately bringing down inflation,” Fratantoni stated.
He noted the housing market has slowed considerably in the past month as interest rates have taken hold.
“We expect that this slower pace will remain through the summer, but buyers could return later this year if the Fed’s plans are better understood by the market and lead to less volatility.”
Hugh Kelly, an economist and columnist for MHN’s sister publication CPE, said the Fed’s actions indicate it’s aiming for an economic soft landing that would slow the economy without a recession. That would enable growth to continue on the demand side for housing and commercial real estate, he said. But Kelly said he is nervous because, “the history of the Fed navigating to a soft landing is abysmal.”
He told MHN that the risk of recession has risen beyond 50-50 and the real estate markets are not ready for that.
“If you bet on continuation of good times and haven’t hedged, then you’re going to be suffering some pain,” Kelly said.
Kelly is not “writing a death knell for any sector of the real estate industry,” but he believes that those who have not prepared are going to be exposed to unacceptable risks.
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